Unit 4 | Types & Characteristics Of Derivative Securities Flashcards
Your customer is long 10 ABC Jul 50 calls at 4.50. How many shares of stock will change hands if the option is exercised?
A. 10
B. 100
С. 1,000
D. 10,000
C. One of the three standardized terms of equity options is that each contract is for 100 shares. Therefore, the exercise of 10 calls (or puts, for that matter) will involve 10 x 100 or 1,000 shares.
The value of a derivative is based on
A. the value of the underlying asset.
B. the value set by the CBOE.
C. the face amount of the derivative.
D. the time until the underlying asset expires.
A | The term derivative is because these securities derive their value from the underlying asset. In the case of equity options, the subject covered on the exam is the stock value that the options are based on. The CBOE is a primary regulator of the options market but has nothing to do with determining value. The term face amount is meaningless, and it is the option that expires, not the underlying corporation.
LO 4.a
All of the following are standardized for equity option except:
A. the size of the contract.
B. the expiration date.
C. the maximum profit.
D. the exercise or strike price.
C | The three standardized features of listed equity options (the only ones covered on the exam) are:
• The size of the contract on the underlying asset—that is, all options on XYZ stock are for 100 shares of the XYZ common stock.
• The expiration date—All options that expire in June (or July or whatever month have the exact date and time of expiry.
• The exercise or strike price—Strike prices are set at standardized intervals.
The amount of profit (or loss) is not standardized. As we’ll see later in this unit, there is potential for an unlimited profit or loss.
LO 4.a
Which of the following statements regarding derivative securities is not true?
A. Derivatives can be sold on securities and nonsecurities.
B. An option contract is a derivative security because it has no value independent of the value of an underlying security.
C. An option contract’s price fluctuates in relationship to the time remaining to expiration and with the price movement of the underlying security.
D. An owner of a put has the obligation to purchase securities at a designated price (the strike price) before a specified date (the expiration date).
D. Although equity options are the most common derivative on the exam, derivatives can be sold on any asset. For example, options exist on foreign currency and commodity futures where the underlying asset is not a security. For this question, an owner of a put has the right, not the obligation, to sell, not purchase, security at a designated price (the strike price) before a specified date (the expiration date). That makes choice D the untrue statement. It is only the seller of an option who has an obligation.
A customer has the right to sell 100 shares of MNO at 60 any time between July and October. Which term best describes this situation?
A. Long call
B. Long put
C. Short call
D. Short put
B. The put buyer (long position) has the right to sell stock to a put writer who is obligated to buy that stock.
GEMCO Manufacturing Company, traded on the NYSE, has announced that it will be issuing 10 million new shares of common stock to raise new capital to purchase new equipment. Your client, owning 1,000 shares of GEMCO common stock, would probably receive
A. an advance invitation to purchase some of the new shares.
B. options to purchase some of the new shares.
C. preemptive rights to purchase some of the new shares.
D. warrants to purchase some of the new shares.
C. Commonly, when a publicly traded company issues new shares of common stock, existing shareholders receive rights, sometimes called stock rights, enabling them to purchase shares in proportion to their current ownership, usually at a reduced price. These rights rarely last longer than 45 days and must be exercised or sold within that time, or they’ll expire worthless. Warrants are not sent to shareholders; they are either purchased in the open market or come attached to a new issue of securities as a “sweetener.”
Which of the following statements concerning put and call options is not correct?
A. One call option is an option to buy 100 shares of a particular common stock at a specified price.
B. A put option permits investors to speculate on a rise in the price of an underlying common stock without buying the stock itself, and a call option allows investors to speculate on a decline in the stock price without short-selling the common stock any time before a specified expiration date.
C. One put option gives the buyer the right to sell 100 shares of a particular common stock at a specified price before a specified expiration date.
D. Options may be used as a hedge against a portfolio position by establishing an
opposite position in the option contracts.
B | It is the call option that permits investors to speculate on a rise in the underlying common stock price without buying the stock itself, and the put option is the alternative to selling stock short.
LO 4.b
All of the following statements describe preemptive rights except
A. they are most commonly offered with debentures to make the offering more attractive.
B. they are short-term instruments that become worthless after the expiration date.
C. a corporation issues them.
D. they are traded in the secondary market.
A | A corporation issues rights to existing shareholders to allow them to purchase enough stock within a short period and at less than the current market price to maintain their proportionate interest in the company. Rights need not be exercised but may be traded in the secondary market. Warrants, not rights, are often issued with debentures to sweeten the offering.
LO 4.c
Forwards are commonly used by producers (farmers) to hedge the risk of the price of the commodity falling before it is able to be harvested and sold. For example, if a farmer has planted soybeans and wishes to hedge against a possible decline in the spot or cash price at delivery, the farmer could
A. buy forward contracts in a size equal to the amount of the soybeans expected to be harvested.
B. buy futures contracts in a size equal to the amount of the soybeans expected to be harvested.
C. sell forward or futures contracts in a size equal to the amount of the soybeans expected to be harvested.
D. sell the soybeans for cash today.
C. Hedging a commodity yet to be harvested is done by selling a forward or a futures contract. Invariably, producers will use forward contracts but could also use a futures contract. In that way, the price is guaranteed in the event of a market decline. However, the producer is giving up any potential gain if the prices rise above the futures/forward agreed-upon one.
An investor takes a long position in a commodity forward contract at a forward price of $105 when the spot price (current market price) is $102. One month later, the spot price has increased to $110. At that time, the forward price of the contract is
A. less than $105.
B. $105.
C. between $105 and $110.
D. more significant than $110.
B | The price of a forward contract is agreed upon between the buyer and seller at initiation. Remember, forward contracts are not standardized like futures contracts. The value of the contract may change during its life, but not the exercise price. Because forwards tend to be confusing, consider this an equity call option. The customer buys a 105 call when the stock’s price is $102. One month later, the stock’s market price has risen to $110. What is the strike price? It is still 105. It’s the same concept here.
LO 4.d
A commodities speculator purchases a 1,000-bushel wheat futures contract for 80 cents per bushel. At expiration, the settlement price is 70 cents per bushel. This individual
A. has a $100 gain.
B. has a $100 loss.
C. must make delivery of the wheat.
D. effectively hedged the long wheat position.
B | The simple math is this: The individual bought at 80 cents and sold at 70 cents, losing 10 cents per bushel. Multiply 10 cents ($.10) by 1,000 bushels, and the loss is $100. The seller is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction before expiration). This individual was long the futures contract, not long (the owner of) the wheat.
LO 4.d
Here is the type of question that is basically easy, but, if you don’t read carefully, you will waste time trying to figure it out.
Among the purposes of purchasing derivatives would be all of the following except
A. hedging.
B. income.
C. profits.
D. speculation.
B. Purchase of a derivative, whether an option, a forward, or a futures contract, never generates income. Selling one does, but the question refers to a purchaser, so the correct answer is choice B.
The term derivative would not include
A. futures on commodities.
B. interest rate swaps.
C. REITs.
D. LEAPS.
C | A derivative is something that derives its value from something else. REITs represent direct investment into real estate; the asset purchase is the actual asset. LEAPS are the options with long-term expiry. Have you never heard of interest rate swaps? Well, on the actual exam, there will occasionally be an answer choice that you’ve never heard of, but it should not affect your ability to choose the correct one.
LO 4.e
Writing options can be a valuable method of generating income for your customer’s portfolio. One issue to be considered is that
A. the income is generally tax-free.
B. the income is generally taxed as short-term gain.
C. the income is generally taxed as a long-term gain.
D. the writer of the option controls whether or not the option is exercised.
B | The nature of selling options is such that the
IRS generally considers the income generated to be taxable as a short-term gain. Currently, the tax rate on those gains is significantly higher than on long-term gains. It is the owner (holder) of the option, not the writer, who has control over the decision to exercise. Note that for testing purposes, invariably, when two choices are mutually exclusive (taxed short-term or long-term), one of those will be the correct answer.
LO 4.e
